The Balance of Payments, Australia and the sub-prime crisis

One of the things that has been puzzling me about the US sub-prime crisis is just why it should have such effects on Australia. Our direct US exposure is minimal, while there is no evidence at this point that the local low-docs loan equivalents suffer from the same problems, yet the effects continue to reverberate.

I could understand it when local home lender RAMS struck trouble because this otherwise solvent firm depended directly on shorter term US borrowings. But why was the US crisis creating domestic liquidity problems, forcing Australia's Reserve Bank to pump funds into the economy?

Thanks to an article by Brian Toohey in the Australian Financial Review (17 December) quoting HSBC Chief Economist John Edwards, I now understand. The answer proved simple but, I think, very serious.

Australia has long had a substantial deficit on the balance of payments current account, a deficit funded by capital flows, mainly through international borrowings by Australian financial institutions. The sub-prime crisis has largely stopped those borrowings.

This created a ricochet effect.

Borrowers such as RAMS dependent on offshore borrowings tried to borrow locally, increasing local demands for funds. More broadly, reduced capital inflows meant that cash stopped coming in to fund the current account deficit, draining cash from the Australian economy. Then, too, there was a reduction in lending between local financial institutions, further reducing the supply of loanable funds.

In normal circumstances, this would have been accommodated in part by a rise in interest rates rationing credit, in part by a fall in the value of the Australian dollar thus choking of imports. However, because of the scale of impacts, the Reserve Bank chose to push liquidity into the Australian economy. This meant, among other things, that we were funding the deficit on the current by reducing the RBA's holdings of foreign currencies. As a consequence, the RBA's official reserve assets fell from $A79.7 billion at the end of June to $A32.7 billion at the end of November.

This is unsustainable in the longer term. If it continues, the RBA will have to borrow internationally to fund the current account deficit, let the currency fall to a new equilibrium level, or some combination of the two. Whichever way it goes, Australia is in a degree of trouble.